The US Dollar, the official currency of the United States, has recently seen a lot of ups and downs. Addressing these developments has become a priority for governments, financial analysts, and investors. The world’s most traded currency is effectively a public utility owned by the American people. It has a huge effect on international markets. That dollar is central to $6.6 trillion worth of daily transactions. This huge number really shows just how powerful and central it is to international finance.
The US Dollar is the main currency in use in the United States. It further serves as the ‘de facto’ currency in most countries around the world. In many areas, it travels in parallel with local currencies, a testament to its acceptance, adaptability and utility. This article explores the factors influencing the value of the US Dollar, particularly the policies enacted by the Federal Reserve (Fed), and how these influence both domestic and international economic landscapes.
The Role of the Federal Reserve
The Federal Reserve Board is crucial to making sense of the US Dollar’s boom and bust cycles. It serves as the country’s central bank and is one of the most important drivers of the nation’s monetary policy. The Fed’s dual mandate is to work toward price stability—that is, control of inflation—and full employment.
To meet these somewhat contradictory mandates, the Fed uses one primary tool—adjusting interest rates. Once inflation goes back down below their 2% target, the Fed can start lowering interest rates again. Unless the average unemployment rate climbs too much, they don’t act. This kind of move almost always leads to a significant US Dollar devaluation. By reducing the interest rates on dollar-denominated assets, the Fed is reducing their attractiveness to foreign investors. Whenever inflation goes above the 2% target, the Fed does something about it. They’ll likely increase interest rates in an attempt to lower inflation, which typically increases the strength of the dollar.
Recent decisions by the Fed, including the current slowdown, have exposed these dynamics. Inflation rates appeared to skyrocket immediately following the pandemic. In order to stabilize the economy, the Fed responded by raising interest rates to get a handle on these ballooning prices. This decision had immediate effects on dollar valuation, further strengthening it against its competitor currencies.
Quantitative Easing and Its Impact
The idea of Quantitative Easing (QE) has been another major factor in driving the fortunes of the US Dollar. QE, or quantitative easing, is an unconventional monetary policy deployed by the Fed. They increase credit availability in an otherwise stagnant financial system by purchasing government-backed securities. This process consists of printing additional US Dollars and employing them to purchase these securities largely from non-financial institutions.
Though QE is a powerful tool to stimulate economic activity through encouraging lending and investment, it is inherently dollar-negative. The over-saturation of dollars on the market reduces their value against other currencies. If history is any guide, episodes of large-scale QE have gone hand-in-hand with a loss of confidence in the dollar’s value.
For instance, in the wake of the COVID-19 pandemic, the Fed undertook aggressive QE measures to steady the economy. While these moves were absolutely necessary to provide immediate economic relief, the increasing doubts about long-term inflation and depreciation of the currency followed closely behind.
The Shift Towards Quantitative Tightening
To combat increasing inflationary pressures, the Federal Reserve has started to pivot away from its previous policy of Quantitative Easing (QE), to QT. This process includes stopping new bond purchases and letting previously purchased bonds mature and exit its balance sheet without reinvestment. QT marks a reversal of QE and is specifically designed to pull money supply out of circulation.
QT’s implications on the strength, or threatened weakness, of the US Dollar is a big deal. When the Fed withdraws liquidity from the financial system, this generally has the effect of strengthening the dollar. To investors, a tighter monetary policy is partly interpreted as a statement of fiscal responsibility. This perception, whether or not it is true, can increase people’s confidence in the currency.
The previous shift from QE to QT was certainly widely observed by market participants. Financial analysts are predicting this shift will have a major impact on interest rates. It will have a dramatic impact on other key economic indicators as well—in particular, inflation and employment levels.
Global Implications
Unstable US Dollar has impacts that extend far beyond the United States’ borders. The dollar continues to rule the global foreign exchange market, making up more than 88% of all turnover. Its strength or weakness has a major impact on international trade competitiveness and foreign direct investment. Countries that depend on dollar-denominated commodities or debt will see their economic stability put at risk should the value of the dollar drop.
Moreover, countries that have the dollar as their sole reserve currency are especially vulnerable to the dollar’s value decreasing. Many countries hold dollars as part of their foreign exchange reserves, relying on its stability for trade and investment purposes. Consequently, even small or modest changes in dollar value can produce economic domino effects around the globe.
In recent months, elevated inflationary pressures have been the key forces behind hawkish pivot Fed policy. In response, many countries have started to reconsider their dependence on the US Dollar. Countries around the world are deepening and widening their ponds. They want to diversify their reserves and reduce their vulnerability to the dollar’s value going up or down.